Understanding Excess Cash Flow: Definitions, Formulas, and Examples

What Is Excess Cash Flow?

Excess cash flow is the portion of a company’s cash flow that is mandated for lender repayment. These repayments stem from loan agreements or bond indentures.

Excess cash flow typically results from revenues or investments that surpass expected figures and trigger a payment to the lender as stipulated in their credit agreement.

Credit agreements usually have restrictive covenants that govern how excess cash is used and expand credit risk coverage for lenders or bond investors.

Lenders and companies negotiate credit agreement terms, including the calculation of excess cash flow, which varies based on individual credit agreements.

Trigger events for mandatory lender payments include new capital raised or profitable asset sales.

How Excess Cash Flows Work in Loan Agreements

Excess cash flows conditions are written into loan agreements or bond indentures as restrictive covenants to provide additional cover for credit risk for lenders or bond investors. If an event occurs that results in excess cash flows as defined in the credit agreement, the company must make a payment to the lender. The payment is often a percentage of the excess flow, depending on the event that generated it.

Lenders thus impose restrictions on how excess cash can be spent in an effort to maintain control of the company’s cash flow. But the lender must also be careful that these restrictions and limitations are not so strict that they impede the company’s financial standing or ability to grow, which could end up causing self-inflicted harm to the lender.

Lenders usually define what is considered excess cash flow by a formula that consists of a percentage or amount above and beyond expected net income or profit over some time period. However, that formula will vary from lender to lender, and it is up to the borrower to negotiate these terms with the lender.

Triggers for Mandatory Lender Payments

If a company raises capital, like through stock issuance, it likely must pay the lender the amount generated minus the expenses. For example, if a company issues new equity in a secondary offering, the money raised would trigger a payment to the lender. Also, if a company issues debt through a bond offering, the proceeds would likely trigger a payment to the lender.

Asset sales could also trigger a payment. A company might have investments or hold shares such as a minority interest in other companies. If the company sold those investments for a profit, the lender would likely require payment for those funds. Proceeds earned from a spinoff, acquisition, or windfall income from winning a lawsuit may also trigger the clause.

Evaluating Exceptions to Excess Cash Flow Payments

Certain sales, like inventory, might not trigger a payment. A company in its normal course of operation might need to buy and sell inventory to generate its operating income. Thus, inventory sales are typically exempt from a prepayment obligation.

Other operating expenses or capital expenditures (CapEx) might be exempt from triggering a payment, such as cash used as deposits to land new business or cash held at a bank that’s used to help pay for a financial product that hedges market risk for the company.

Methods to Calculate Excess Cash Flows

There’s no set formula for excess cash flows, as each credit agreement has different payment requirements. An approximation of a calculation of excess cash flow could begin with taking the company’s profit or net income, adding back depreciation and amortization, and deducting capital expenditures that are necessary to sustain business operations, and dividends, if any.

In other words, a credit agreement might outline an amount of excess cash flow that triggers a payment, but also how cash is used or spent. A lender might allow cash to be used for business operations, possibly dividends, and certain capital expenditures. The terms defining excess cash flow and any payments are typically negotiated between the borrower and the lender.

If excess cash flow is generated, a lender might require a payment that is 100%, 75%, or 50% of the excess cash flow amount.

Excess Cash Flows Compared to Free Cash Flows

Free cash flow (FCF) is the cash a company produces through its operations, less the cost of expenditures on assets. In other words, free cash flow is the cash left over after a company pays for its operating expenses and capital expenditures.

FCF shows how efficient a company is at generating cash. Investors use free cash flow to measure whether a company might have enough cash, after funding operations and capital expenditures, to pay investors through dividends and share buybacks.

The excess cash flow amount for a company is different from a company’s free cash flow figure. Excess cash flow is defined in the credit agreement, which might stipulate for certain expenditures to be excluded in the calculation of excess cash flow. Exceptions to excess cash flow might be taxes paid and cash used to generate new business, but these cash outlays would be included in the free cash flow calculation.

Real-World Example: Excess Cash Flow at Dunkin’ Brands

In 2010, Dunkin’ Brands Inc. entered into a credit agreement with Barclays Bank PLC and a number of other lenders for a $1.25 billion term B loan and $100 million revolving lines of credit.

Below are the legal terms used in the credit agreement defining excess cash flow. Under “Defined Terms” of the agreement, excess cash flow is spelled out in a verbal formula as “an amount equal to the excess of”:

• (a) the sum, without duplication, of:
• Consolidated net income of the borrower for such period
• An amount equal to the amount of all noncash charges (including depreciation and amortization)
• The consolidated working capital adjustment for such period

Over:

• (b) the sum, without duplication, of:
• An amount of all noncash gains, income, and credits included in arriving at such Consolidated Net Income
• The [dollar] amount of capital expenditures, capitalized software expenditures, and acquisitions
• Consolidated Scheduled Funded Debt Payments
• The [dollar] amount of Investments made in cash … made during such period to the extent that such Investments were financed with Internally Generated Cash Flow, plus any Returns of such Investment
• The aggregate consideration to be paid in cash … relating to permitted acquisitions

All the capitalized terms in the above excerpt are “Defined Terms” in the agreement. The excess of “(a)” items over “(b)” items is carefully laid out as the definition of excess cash flow. The highlighted items in the above example are by no means exhaustive; instead, they illustrate the fine details of a definition of excess cash flow.

Numerical Illustration of Excess Cash Flow Calculation

Say that hypothetical Company A has the following financial results at the end of the year:

• Net income: $1,000,000
• Capital expenditures for operations: $500,000
• Interest paid on debt with cash: $100,000

Assume that both CapEx and the interest paid are allowed under the credit agreement, meaning the company can use cash for those expenses. However, any cash left over after deducting the expenses from net income would be considered excess and trigger a payment to the lender.

• Excess cash flow: $400,000 or ($1,000,000 – $500,000 – $100,000)
• Percentage of excess cash flow for payment: 50%
• Payment due to lender: $200,000 or ($400,000 * 50%)

The Bottom Line

Excess cash flow is a mechanism for lenders to ensure debt repayment. What constitutes it is often spelled out in a loan agreement, which requires a company to repay cash generated beyond normal operations to a lender.

Negotiating the terms of excess cash flow with lenders must strike a balance between the lender’s requirements and the company’s financial health.

Potential triggers for required payments from excess cash flows include additional capital from issued stock or profits from asset sales.

Excess cash flows differ from free cash flows in that the former are determined by credit agreements and may exclude certain expenses, while the latter are the cash remaining after a company pays operating expenses and capital expenditures.

The example of Dunkin’ Brands Inc. above demonstrates real-world applications of negotiated excess cash flow clauses.

Although excess cash flow is an important financial metric, it may not fully reflect a company’s financial health since it is defined by lender-specific requirements.